Financial Stability Standards for Securities Settlement Facilities – December 2012 Standard 2: Governance

Guidance

Governance is the set of relationships between a securities settlement facility's owners, board of directors (or equivalent), management and other relevant parties, including participants, the Reserve Bank and other relevant authorities, and other stakeholders (such as participants' customers, other interdependent FMIs and the broader market). Governance provides the processes through which an organisation sets its objectives, determines the means for achieving those objectives and monitors performance against those objectives. Good governance provides the proper incentives for a securities settlement facility's board and management to pursue objectives that are in the interests of its stakeholders and that support relevant public interest considerations.

2.1.1 Given the importance of securities settlement facilities and the fact that their decisions can have widespread impact, affecting multiple financial institutions, markets and jurisdictions, it is essential for each securities settlement facility to place a high priority on the safety of its operations and explicitly support financial stability and other relevant public interests. This is consistent with a securities settlement facility's obligations under section 821A(aa) of the Corporations Act 2001, which states that a CS facility must, to the extent that it is reasonably practicable to do so, not only comply with standards determined by the Reserve Bank under section 827D, but also do all other things necessary to reduce systemic risk. A securities settlement facility's governance arrangements should also include appropriate consideration of the interests of participants, participants' customers, the Reserve Bank and other relevant authorities, and other stakeholders. Governance arrangements should provide for fair and open access, insofar as this would not be inconsistent with the maintenance of acceptable risk control standards (see SSF Standard 15 on access and participation requirements) or the effective implementation of recovery or wind-down plans, or resolution.

2.2.1 Governance arrangements, which define the structure under which the board and management operate, should be clearly and thoroughly documented. These arrangements should include certain key components such as the: role and composition of the board and any board committees; senior management structure; reporting lines between management and the board; ownership structure; internal governance policy; design of risk management and internal controls; procedures for the appointment of board members and senior management; and processes for ensuring performance accountability. Governance arrangements should provide clear and direct lines of responsibility and accountability, particularly between management and the board, and ensure sufficient independence for key functions such as risk management, internal control and audit. These arrangements should be disclosed to owners, the Reserve Bank and other relevant authorities, participants and, at a more general level, the public.

2.2.2 No single set of governance arrangements is appropriate for all securities settlement facilities and all market jurisdictions. Arrangements may differ significantly because of national law, ownership structure or organisational form. Indeed, a securities settlement facility may be owned by its participants or by another organisation, may be operated as a for-profit or not-for-profit enterprise, or may be organised as a bank or non-bank entity. While specific arrangements vary, this Standard is intended to be generally applicable to all ownership and organisational structures.

2.2.3 Depending on its ownership structure and organisational form, a securities settlement facility may need to focus particular attention on certain aspects of its governance arrangements. For instance, a securities settlement facility that is, or is part of, a for-profit entity may need to place particular emphasis on managing any conflicts between income generation and safety. And a securities settlement facility that is part of a larger organisation or corporate group should consider any conflicts of interest or other issues that may arise from its relationship to its parent or to other affiliated entities (see SSF Standard 2.9).^[1] Where relevant, any cross-border issues should also be appropriately identified, assessed and dealt with in the facility's governance arrangements, both at the level of the securities settlement facility and at the level of its parent. A securities settlement facility's ownership structure and organisational form may also need to be considered in the preparation and implementation of its recovery or wind-down plans or in assessments of its resolvability.

2.3.1 A securities settlement facility's board has multiple roles and responsibilities that should be clearly specified. These roles and responsibilities should include: establishing clear strategic aims for the entity; ensuring effective monitoring of senior management (including selecting its senior managers, setting their objectives, evaluating their performance and, where appropriate, removing them); establishing appropriate compensation policies (which should be consistent with best practices and based on long-term achievements, in particular, the safety of the securities settlement facility – see paragraph 2.5.2); establishing and overseeing the risk management function and material risk decisions; overseeing internal control functions (including ensuring independence and adequate resources); ensuring compliance with all supervisory and oversight requirements; ensuring consideration of financial stability and other relevant public interests; and providing accountability to the owners, participants and other relevant stakeholders (see SSF Standard 2.8). The means by which the board discharges these responsibilities may vary according to the securities settlement facility's organisational form. Where a securities settlement facility forms part of a corporate group, some of the roles and responsibilities of the board may be carried out on a group-wide basis, for instance by the board of the securities settlement facility's parent company. However, the securities settlement facility must be able to demonstrate that any such alternative governance arrangements are effective. In particular, the securities settlement facility should be able to demonstrate that such arrangements uphold its capacity to meet its regulatory and other obligations, and in no way compromise or subordinate the securities settlement facility's interests to the interests of the group (see SSF Standard 2.9).

2.3.2 Policies and procedures related to the functioning of the board should be clear and documented. These policies include the responsibilities and functioning of board committees. A board would normally be expected to have, among others, a risk committee, an audit committee and a compensation committee, or equivalents (including equivalent committees operating on a group-wide basis). All such committees should have clearly assigned responsibilities and procedures.^[2] Board policies and procedures should include processes to identify, address and manage potential conflicts of interest of board members. Conflicts of interest include, for example, circumstances in which a board member has material competing business interests with the securities settlement facility. Further, policies and procedures should also include regular reviews of the board's performance and the performance of each individual member, as well as, potentially, periodic independent assessments of performance.

2.4.1 Governance policies related to board composition, appointment and term should also be clear and documented. The board should be composed of suitable members with an appropriate mix of skills (including strategic and relevant technical skills), experience, competence and knowledge of the entity (including an understanding of the securities settlement facility's interconnectedness with other parts of the financial system). The nature and degree of the skills, experience and expertise required of board members will depend on the size, scope and nature of the business conducted by the securities settlement facility. Members should also have a clear understanding of their roles in corporate governance, be able to devote sufficient time to their roles, ensure that their skills remain up to date and have appropriate incentives to fulfil their roles. Members should be able to exercise objective and independent judgement. A securities settlement facility should be able to demonstrate that its board composition provides a sufficient degree of independence from the views of management. This typically requires the inclusion of non-executive board members, including independent board members.^[3] The key characteristic of independence is the ability to exercise objective, independent judgement after fair consideration of all relevant information and views and without undue influence from executives or from inappropriate external parties or interests. The precise definition of independence used by a securities settlement facility should be specified and publicly disclosed. A securities settlement facility should also specify and publicly disclose any relevant interests of its board members, as well as any arrangements that it has in place to manage any potential conflicts arising from these interests. Such interests may include relevant business or commercial interests, cross-directorships, shareholdings, or employee relationships. Further, a securities settlement facility should publicly disclose which board members it regards as independent. The appropriate number of independent non-executive directors on a securities settlement facility's board will depend on the size, scope and nature of the business conducted by the securities settlement facility. A securities settlement facility may also need to consider setting a limit on the duration of board members' terms.

Roles and responsibilities of management

2.5.1 A securities settlement facility should have clear and direct reporting lines between its management and board in order to promote accountability, and the roles and responsibilities of management should be clearly specified. A securities settlement facility's management should have the appropriate experience, mix of skills and integrity necessary to discharge its responsibilities for the operation and risk management of the securities settlement facility. Under board direction (or equivalent alternative governance arrangements), management should ensure that the securities settlement facility's activities are consistent with the objectives, strategy and risk tolerance of the securities settlement facility, as determined by the board (or equivalent). Management should ensure that internal controls and related procedures are appropriately designed and executed in order to promote the securities settlement facility's objectives, and that these procedures include a sufficient level of management oversight. Internal controls and related procedures should be subject to regular review and testing by well-trained and staffed risk management and internal audit functions. Additionally, senior management should be actively involved in the risk control process and should ensure that appropriate resources are devoted to the securities settlement facility's risk management framework.

Compensation

2.5.2 A securities settlement facility should structure compensation arrangements for management to provide incentives for sound and effective risk management. The securities settlement facility should consider offering incentives that reward management for effective risk management and the longer-term financial soundness of the facility. Fundamentally, the securities settlement facility should avoid compensation arrangements that create incentives for management to pursue greater profitability by relaxing risk controls.

Risk management governance

2.6.1 Because the board is ultimately responsible for managing a securities settlement facility's risks, it should establish a clear, documented risk management framework that includes the securities settlement facility's risk tolerance policy, assigns responsibilities and accountability for risk decisions, and addresses decision-making in crises and emergencies. The board should regularly monitor the securities settlement facility's risk profile to ensure that it is consistent with the securities settlement facility's business strategy and risk tolerance policy. In addition, the board should ensure that the securities settlement facility has an effective system of controls and oversight, including adequate governance and project management processes, over the models used to quantify, aggregate and manage the securities settlement facility's risks. Board approval should be required for material decisions that would have a significant impact on the risk profile of the entity, such as the limits for total credit exposure and large individual credit exposures. Other material decisions that may require board approval include the introduction of new products, implementation of new links, use of new crisis management frameworks, adoption of processes and templates for reporting significant risk exposures, and adoption of processes for considering adherence to relevant market protocols.

2.6.2 The board, and governance arrangements more generally, should support the use of clear and comprehensive rules and key procedures, including detailed and effective participant default rules and procedures (see SSF Standard 11 on participant default rules and procedures). Governance arrangements should ensure that procedures are in place to support the board's capacity to act appropriately and immediately if any risks arise that threaten the securities settlement facility's viability as a going concern. The governance arrangements should also provide for effective decision-making in a crisis and support any procedures and rules designed to facilitate the recovery or orderly wind-down of the securities settlement facility.

2.6.3 In addition, the governance of the risk management function is particularly important. It is essential that a securities settlement facility's risk management personnel have sufficient independence, authority, resources and access to the board to ensure that the operations of the securities settlement facility are consistent with the risk management framework set by the board. The reporting lines for risk management should be clear and separate from those for other operations of the securities settlement facility, and there should be an additional direct reporting line to a non-executive director on the board via a chief risk officer (or equivalent). To help the board discharge its risk-related responsibilities, a securities settlement facility should have a risk committee, responsible for advising the board on the securities settlement facility's overall current and future risk tolerance and strategy. A securities settlement facility's risk committee should be chaired by a sufficiently knowledgeable individual who is typically independent of the securities settlement facility's executive management and should typically be composed of a majority of members who are non-executive members. The committee should have a clear and public mandate and operating procedures and, where appropriate, have access to external expert advice.

Model validation

2.6.4 The board should ensure that there is adequate governance surrounding the adoption and use of models, such as for credit, collateral and liquidity risk management systems. A securities settlement facility should validate, on an ongoing basis, the models and their methodologies used to quantify, aggregate and manage the securities settlement facility's risks. The validation process should be independent of the development, implementation and operation of the models and their methodologies, and should be subject to an independent review of its adequacy and effectiveness. Validation should include: an evaluation of the conceptual soundness of (including developmental evidence supporting) the models; an ongoing monitoring process that includes verification of processes and benchmarking; and an analysis of outcomes that includes backtesting.

2.7.1 Governance arrangements should establish and provide for appropriate oversight of internal controls and audit. A securities settlement facility should have sound internal control policies and procedures to help manage its risks. For example, as part of a variety of risk controls, governance arrangements should ensure that there are adequate internal controls to protect against the misuse of confidential information. A securities settlement facility should also have an effective internal audit function, with sufficient resources and independence from management to provide, among other activities, a rigorous and independent assessment of the effectiveness of a securities settlement facility's risk management and control processes (see also SSF Standard 3 on the framework for the comprehensive management of risks). Governance arrangements should typically establish an audit committee to oversee the internal audit function. In addition to reporting to senior management, the audit function should have regular access to the board (or equivalent) through an additional reporting line.

2.7.2 A securities settlement facility should engage independent and appropriately qualified external experts to review aspects of its operations, risk management processes, internal control mechanisms and accounts periodically and as required. The adequacy of and adherence to control mechanisms may also be assessed through regular independent compliance programs. In particular, external reviews may be required if internal audit processes or other internal controls identify potential areas of weakness that require additional external scrutiny and analysis. The outcomes of periodic or ad hoc external reviews should be provided to the Reserve Bank and other relevant authorities on a timely basis, and the securities settlement facility should advise the Reserve Bank or other relevant authorities as to how it plans to address any areas of weakness identified.

2.8.1 A securities settlement facility's governance arrangements should take into account all relevant stakeholders' interests, including those of its direct and indirect participants, in making major decisions, including those relating to the system's design, rules and overall business strategy. A securities settlement facility with cross-border operations, in particular, should ensure that the full range of views across the jurisdictions in which it operates is appropriately considered in the decision-making process. Mechanisms for involving stakeholders in decision-making processes may include stakeholder representation on the board (including direct and indirect participants), user committees and public consultation processes. Where appropriate, a securities settlement facility should consider establishing targeted stakeholder forums that provide opportunities for focused consultation with specific segments of the participant base, or other stakeholders that have common interests. This might be particularly important where stakeholders vary significantly in size, location or other characteristics. These forums may provide opportunity for stakeholder input on matters such as the securities settlement facility's operational arrangements, risk controls and default management rules and procedures. As opinions among interested parties are likely to differ, the securities settlement facility should have clear processes for identifying and appropriately managing the diversity of stakeholder views and any conflicts of interest between stakeholders and the securities settlement facility. Without prejudice to local requirements on confidentiality and disclosure, the securities settlement facility should clearly and promptly inform its owners, participants, other users and, where appropriate, the broader public, of the outcome of major decisions, and consider providing summary explanations for decisions to enhance transparency where it would not endanger candid board debate or commercial confidentiality.

2.9.1 Where a securities settlement facility is part of a wider corporate group, there may be the potential for conflicts to arise between the obligations and interests of the securities settlement facility and those of other entities in the group (including related functions performed within the same legal entity – see SSF Standard 1.1), or the group as a whole. For example, where a securities settlement facility utilises staff or other resources that are employed or owned by other group entities, there may be circumstances in which it is in the interests of the group to withhold the provision of those resources – for instance, if it appears likely that the securities settlement facility may enter external administration. Conflicts could also arise between the risk management objectives of a securities settlement facility and the business interests of other group entities. A securities settlement facility should therefore ensure that potential conflicts will not prevent it from appropriately managing its risks and fulfilling its regulatory and other obligations. This may include consideration of whether adequate arrangements exist to manage potential conflicts arising from board composition – that is, where directors of other group entities are members of the securities settlement facility's board – or any intragroup outsourcing arrangements (including the sharing of staff or other resources) that exist between the securities settlement facility and other group entities. The securities settlement facility should be able to demonstrate to the Reserve Bank and other relevant authorities that its arrangements to manage potential conflicts are adequate, including through the provision of relevant documented governance policies and procedures.