Financial Stability Standards for Securities Settlement Facilities – December 2012 Standard 5: Collateral

Guidance

Collateralising any credit exposures protects a securities settlement facility and, where relevant, its participants against potential losses in the event of a participant default (see SSF Standard 4 on credit risk). Besides mitigating a securities settlement facility's own credit risk, the use of collateral can provide participants with incentives to manage the risks they pose to the securities settlement facility or other participants. A securities settlement facility should apply prudent haircuts to the value of the collateral to achieve a high degree of confidence that the liquidation value of the collateral will be greater than or equal to the obligation that the collateral secures in extreme but plausible market conditions. Additionally, a securities settlement facility should have the capacity to use the collateral promptly when needed.

5.1.1 A securities settlement facility should generally limit the assets it (routinely) accepts as collateral to those with low credit, liquidity and market risks. Collateral with low credit, liquidity and market risks comprises assets that may be reliably liquidated or repurchased in private markets, within a reasonable time frame and at a value within the haircut applied or, in extremis and where the collateral taker has access, sold to a central bank under a repurchase agreement or otherwise pledged to a central bank. Certain types of collateral that are not considered to have low credit, liquidity and market risks may nevertheless be acceptable collateral for credit purposes if an appropriate haircut is applied. A securities settlement facility must be confident of the collateral's value in the event of liquidation and of its capacity to use that collateral quickly, especially in stressed market conditions. Where a securities settlement facility accepts collateral that does not have low credit, liquidity and market risks, it should demonstrate that it sets and enforces appropriately conservative haircuts and concentration limits (see SSF Standard 5.3).

5.1.2 In general, bank guarantees are not acceptable collateral. However, the use of bank guarantees may be acceptable under certain specified circumstances and under certain conditions, subject to prior approval from the Reserve Bank or other relevant authorities. The Reserve Bank will consider the acceptability of bank guarantees as collateral on a case-by-case basis, taking into account factors including: the credit standing of the bank providing the guarantee; the legal certainty of the arrangement; and whether there is any collateral supporting the guarantee.

5.1.3 Further, a securities settlement facility should regularly review its requirements for acceptable collateral in accordance with changes in underlying risks. When evaluating types of collateral, a securities settlement facility should consider potential delays in accessing the collateral due to the settlement conventions for transfers of the asset. In addition, participants should not be permitted to post their own debt or equity securities, or debt or equity of companies closely linked to them, as collateral. More generally, a securities settlement facility should mitigate specific wrong-way risk by limiting the acceptance of collateral that would likely lose value in the event that the participant providing the collateral defaulted. The securities settlement facility should measure and monitor the correlation between a counterparty's creditworthiness and the collateral posted and take measures to mitigate the risks, for instance by setting more conservative haircuts.

5.1.4 If a securities settlement facility plans to use assets held as collateral to secure liquidity facilities in the event of a participant default, the securities settlement facility will also need to consider, in determining acceptable collateral, what will be acceptable as security to lenders offering liquidity facilities (see SSF Standard 6 on liquidity risk).

5.2.1 A securities settlement facility's collateral policies may have broader effects than their direct implications for the effectiveness of the securities settlement facility's risk controls. On the one hand, assets accepted as collateral by FMIs, including securities settlement facilities, may be more likely to then be held by participants or used as collateral in other contexts, and may become more liquid as a result. On the other hand, use of a particular class of assets to meet collateral obligations at FMIs may, depending on its supply, restrict the availability of such assets for other uses, or significantly affect liquidity and pricing. A securities settlement facility should consider such broader effects when framing its collateral policies.

5.2.2 Participants that are required to source unfamiliar assets as collateral may face additional operational, legal or financial risks as a result. A securities settlement facility should therefore consider allowing the use of collateral that is commonly accepted in each jurisdiction in which it operates. In particular, a securities settlement facility with material Australian-based participation should consider accepting appropriate Australian dollar-denominated securities as collateral.

5.3.1 To provide adequate assurance of the value of collateral in the event of liquidation, a securities settlement facility should establish prudent valuation practices and develop haircuts that are regularly tested and take into account stressed market conditions. A securities settlement facility should, at a minimum, mark its collateral to market daily. Haircuts should reflect the potential for asset values and liquidity to decline over the interval between their last revaluation and the time by which a securities settlement facility can reasonably assume that the assets can be liquidated. Haircuts also should incorporate assumptions about collateral value during stressed market conditions and reflect regular stress testing that takes into account extreme price moves, as well as changes in market liquidity for the asset. If market prices do not fairly represent the true value of the assets, a securities settlement facility should have the authority to exercise discretion in valuing assets according to predefined and transparent methods. A securities settlement facility's haircut procedures should be independently validated at least annually.^[16]

5.4.1 A securities settlement facility should appropriately address procyclicality in its collateral arrangements. To the extent practicable and prudent, a securities settlement facility should establish stable and conservative haircuts that are calibrated to include periods of stressed market conditions in order to reduce the need for procyclical adjustments. In this context, procyclicality typically refers to changes in risk management practices that are positively correlated with market, business or credit cycle fluctuations and that may cause or exacerbate financial instability. While changes in collateral values tend to be procyclical, collateral arrangements can increase procyclicality if haircut levels fall during periods of low market stress and increase during periods of high market stress. For example, in a stressed market, a securities settlement facility may require the posting of additional collateral both because of the decline in asset prices and because of an increase in haircut levels. Such actions could exacerbate market stress and contribute to driving down asset prices further, resulting in additional collateral requirements. This cycle could exert further downward pressure on asset prices. Addressing issues of procyclicality may create additional costs for securities settlement facilities and their participants in periods of low market stress because of higher collateral requirements, but result in additional protection and potentially less costly and less disruptive adjustments in periods of high market stress.

5.5.1 A securities settlement facility should avoid concentrated holdings of certain assets where this would significantly impair the ability to liquidate such assets quickly without significant adverse price effects, including in stressed market conditions. High concentrations within holdings can be avoided by establishing concentration limits or imposing concentration charges. Concentration limits restrict participants' ability to provide certain collateral assets above a specified threshold as established by the securities settlement facility. Concentration charges penalise participants for maintaining holdings of certain assets beyond a specified threshold as established by the securities settlement facility. Further, concentration limits and charges should be constructed to prevent participants from covering a large share of their collateral requirements with the most risky assets acceptable. Concentration limits and charges should be periodically reviewed by the securities settlement facility to determine their adequacy.

5.6.1 If a securities settlement facility accepts cross-border collateral, it should identify and mitigate any additional risks associated with its use and ensure that it can be used in a timely manner.^[17] A cross-border collateral arrangement can provide an efficient liquidity bridge across markets, help relax collateral constraints for some participants and contribute to the efficiency of some asset markets. These linkages, however, can also create significant interdependencies between a securities settlement facility and other FMIs, and risks to the securities settlement facility that need to be evaluated and managed (see also SSF Standard 14 on operational risk and SSF Standard 17 on FMI links). For example, a securities settlement facility should have appropriate legal and operational safeguards to ensure that it can use the cross-border collateral in a timely manner and should identify and address any significant liquidity effects. A securities settlement facility also should consider foreign exchange risk where collateral is denominated in a currency different from that in which the exposure arises, and set haircuts to address the additional risk to a high level of confidence. The securities settlement facility should have the capacity to address potential operational challenges of operating across borders, such as differences in time zones or operating hours of foreign central securities depositories or custodians.

Collateral management systems

5.7.1 A securities settlement facility should use a well-designed and operationally flexible collateral management system. Such a system should accommodate changes in the ongoing monitoring and management of collateral. A collateral management system should track the extent of reuse of collateral (both cash and non-cash) and the rights of a securities settlement facility to the collateral provided to it by its counterparties. Where appropriate, a securities settlement facility's collateral management system should also have functionality to accommodate the timely deposit, withdrawal, substitution and liquidation of collateral in each jurisdiction in which it operates. In particular, where the scope of Australian participation in the securities settlement facility is material, and where market conventions dictate, a securities settlement facility's collateral management system should have the capacity to accommodate the timely deposit, withdrawal, substitution and liquidation of collateral during Australian market hours. A securities settlement facility should allocate sufficient resources to its collateral management system to ensure an appropriate level of operational performance, efficiency and effectiveness. Senior management should ensure that the securities settlement facility's collateral management function is adequately staffed to ensure smooth operations, especially during times of market stress, and that all activities are tracked and reported, as appropriate, to senior management.^[18]

Reuse of collateral

5.7.2 Reuse of collateral refers to the securities settlement facility's subsequent use of collateral that has been provided by participants in the normal course of business. This differs from the securities settlement facility's use of collateral in a default scenario during which the defaulter's collateral, which has become the property of the securities settlement facility, can be used to access liquidity facilities or liquidated to cover losses (see SSF Standard 11 on participant default rules and procedures). A securities settlement facility should have clear and transparent rules regarding the reuse of collateral (see SSF Standard 18 on disclosure of rules, key policies and procedures and market data). In particular, the rules should clearly specify when a securities settlement facility may reuse its participant collateral and the process for returning that collateral to participants. In general, a securities settlement facility should not rely on the reuse of collateral as an instrument for increasing or maintaining its profitability. However, a securities settlement facility may invest any cash collateral received from participants on their behalf (see SSF Standard 13 on custody and investment risks).